Whereas the setup and adjustments of the computer systems, including search engines of said co-pending applications and publications for the holding of on-line live auctions for goods and services, is particularly described therein, the architecture system and set up for bundled financial instruments, including operating a pricing and risk control strategy for internet-auctioned credit default swaps, using various risk and quality factors, is quite different and novel for such auctioning by the automatic computing of such bid prices for credit default swaps and the like. It is thus in order first to examine the unique problems created by such bundled financial instruments as credit default swapping, and as contrasted from individual goods and services.
A credit default swap (CDS) is a derivative financial transaction and instrument that, to the detriment of the current worldwide economy, is often used to hedge against the potential default of an obligor on a debt instrument, such as bonds or secured debts—particularly, mortgages—and specifically where such are bundled together with other unrelated debt instruments of others and used as relatively new types of financial derivative instruments for such potential default hedging.
Typically, there are three primary entities that participate in the creation and bundling of such diverse assets for the buying and selling of a CDS: (1) the underlying entity issuing the debt, (2) the seller of the CDS, and (3) the buyer. The obligor of the debt, sometimes referred to herein as the “reference entity” (see later-described FIG. 1), is the entity for whose debt the coverage is being bought and sold. There may be many types of such reference entities, such as corporations that issue debt directly, entities owning a pool of assets such as a securitized pool of mortgages, credit card debt or auto loans; or in some instances, it may be an index. The “buyer” (typically a hedge fund or a mutual fund) purchases the CDS in the market from sellers, usually as a hedge position against other assets under management. The “seller” (usually an investment bank) acts as the underwriter and dealer and guarantees payments to the buyer should the reference entity default on the debt.
In some instances, the seller purchases insurance from a primary insurer to cover its risk should the reference entity default, or the seller's capital reserve is not sufficient to pay against the demand, or other major market fluctuations. Secondary insurance may also be purchased to further limit the risks of the parties.
The buyer of a CDS is not required to own the underlying bonds of the reference entity. The CDS provides downside protection when markets turn negative as debt default rates for businesses go higher, and the corresponding equity prices drop, and as a result the bond ratings go down. Because the income stream generated by the CDS was based on better market conditions, its value increases, thus offsetting some of the losses.
Since the CDS market is largely over-the-counter (OTC), there is little visibility into the risks associated with the various entities that participate in the market. As such, there is currently no meaningful mechanism to arrive at an accurate market price that reflects the quality of each entity and of the underlying debt instruments, which results in significant pricing inefficiencies.
As an example, a hedge fund may wish to purchase coverage for $10 M of ‘AA’ rated Ford Motor Company bonds from an underwriter (seller) in the form of a CDS. The seller evaluates the Ford bonds, the various credit agency ratings of the bonds, the status of the company in current market conditions, and the prospects for future growth (or lack thereof)—determining a price, typically using internal, proprietary pricing models. A private transaction is then consummated between the hedge fund and the investment bank having particular timing (typically between three and ten years) and payment terms.
The CDS market is a highly lucrative business whose original intent was to provide entities with a way to hedge against debt default. Over the past decade, the size of the CDS market has multiplied many-fold, resulting in tens of trillions of dollars of notional value for which, however, there is no reserve. To complicate matters, buyers of the CDS instruments cannot accurately quantify their risk exposure when purchasing such instruments, nor is there any structured, repeatable process to accurately discover and validate pricing at the time of purchase or resale. These same risks plague the insurance companies providing the coverage to the underwriter.
Because the terms of CDS transactions are confidential, moreover, none of the buyer, seller or insurance companies has the necessary visibility into each other's aggregated risk positions in order to accurately assess the true value of the CDS. As a result, the margin on an appropriate risk premium is significantly higher.
For example, while certain pricing models are assumed to account for the risks associated with the reference entity (which is not always the case, as explained below), such models do not account for the default risk or the increased risk of failure of the underwriter itself, or those of its insurance companies. Thus, the buyer of the CDS may have accounted for the risk associated with the reference entity, but remains largely exposed to risks associated with the underwriter. To further compound the exposure, default risks associated with the primary and secondary insurance companies are also not factored into the CDS pricing model.
Any catastrophic failure of an underwriter, accordingly, will necessarily result in a loss of coverage for bonds held by the numerous entities who bought the CDS assets as a hedge against the bonds, forcing the sale of the bonds at pennies on the dollar. Furthermore, hedge funds that bought the CDS assets as a potential hedge to protect their position in the underlying security, or as pure speculation, will not be able to collect the gains, causing a panic in the market with disastrous consequences. Such effects are multiplied when the insurer of the risks does not have sufficient reserves, and/or the risks were not appropriately distributed among other insurance companies, resulting in further market collapse.
Another issue that limits the ability of the parties to accurately price CDS assets is so-called “digital discontinuity”, and the differences in resolutions of the debt ratings at various stages of the process.
Consider, as an illustration, a pool of mortgage-backed securities comprising mortgages to individuals across the credit score spectrum. Individuals having a credit score below 580 are typically considered sub-prime borrowers; those above a score of 620 are classified as either ‘alt A’ or ‘A Paper’ depending upon the quality of the documentation and the ratio of monthly payment to income, and others are classified as “Optional ARM”. Using these groupings, mortgages may be categorized into four classes of debt. In practice, this is analogous to using an analog-to-digital (A/D) conversion having a 25% resolution. The mortgage broker or bank and/or other intermediaries then create pools of mortgages having these designations and sell them to investment banks. The investment banks then use the debt-rating agencies and apply another, higher-resolution digitization scheme—effectively using a second-stage, higher bit A/D converter. The investment banks then carefully mix and match assets to create pools such that the new pools barely meet the requirements of a quality rating, taking advantage of the digital discontinuity.
As an example, consider a pool that can barely acquire a rating of ‘AA’. Once assigned this rating (and no matter how many sub-prime mortgages are in it), no distinction is made between it and other debt pools that were not deliberately so packaged and are truly ‘AA’ rated debt. Considering that the original resolution at the origination of a mortgage was much coarser, the refinement of the resolution in the second stage is gated by the first stage resolution. Once the pools are established, the investment banks issue bonds, which in turn may be rated based on the overall credit risk of the bank—again obfuscating the actual quality of the underlying debt. The bond buyer may now purchase a CDS based on the debt, but because the actual quality and risk of the debt pool has been manipulated, the determining of a true price for the CDS is difficult.
Even the existing reference entity default risk pricing models suffer from serious limitations. Although they tend to work well while the borrower and the issuer of the bond are one and the same entity, the accuracy is significantly reduced when that is not the case. For example:                there may be a significant difference between the debt ratings at the origin of the bond in contrast to the current rating of the bond issued by a third party using that debt;        the impact on the overall debt quality is not well understood when asset pools are created for the purposes of securitization and it is very difficult to maintain a consistent quality throughout the pool;        the process of creating the debt pools is not done concurrently with the issuance of the debt, and therefore is sub-optimal;        there is no easy way to update the pool rating if there is deterioration or enhancements in the end borrower's credit quality; and        there is no easy way to continuously monitor the quality of the key characteristics of the pool, thus making any meaningful risk monitoring and risk control difficult.        
In addition to the difficulties of using conventional reference entity risk modeling techniques to price the CDS instrument, the risks associated with the other market participants are virtually ignored. Thus, there are the following primary factors impacting the CDS price and preventing its accurate measurement:                1. Lack of identification, quantification and monitoring of risks for each of the participants, and requisite controls to manage such risk within an acceptable range;        2. lack of identification and quantification of cross connectivity parameters among the participants and the magnitude of risk each one imparts to its other connected participants;        3. ill-defined means to reflect the collective impact of such risks on the final CDS price; and        4. inability to update the price appropriately as the debt quality of the end borrowers evolve as a function of time.        
Taken together, these conditions result in a wide range of disparity in determining a true CDS price, and a lack of any meaningful visibility or control on the part of the market participants to manage the risk, further jeopardizing the validity of the price. This becomes even more troublesome when an existing CDS owner wants to sell a CDS that is “in-the-money”—i.e., it has appreciated in value. Such a purchase requires a cash outlay on the part of the new buyer, thus adding another parameter to the already complicated existing pricing process.
As such, there are numerous questions and concerns that each entity faces when participating in the CDS market, some of which are listed below.